Mock Exam of Corporate Finance Subject

e TCH321 – CORPORATE FINANCE MOCK EXAM Time: 1 hour 30 minutes The exam lasts 1 hour and 30 minutes and consists of 5 questions. Approved calculators are permitted. You are not allowed to use Excel. This is a closed book exam. You are NOT permitted to access any other material in either written or electronic form. All numerical answers should be reported to TWO decimal places. To ensure the accuracy of your answer, you should perform all intermediate calculations to at least THREE decimal places. Choose FIVE questions. DO show your working. Question 1. (20 marks) Suppose that you have the following information about a company Credit rating Beta Tax expense Pre-tax income Preferred dividend rate Preferred stock par value Preferred stock price Preferred stock outstanding Common stock price Common stock par value Common stock outstanding Expected next common stock dividend Long term bond yield-to-maturity Enterprise value Market risk premium 30 year Treasury bond yield-to-maturity AA 0.95 14,325,000 113,895,000 5.25% $100.00 $101.25 13,000,000 $53.29 $25.00 50,000,000 $1.95 7.55% 4,945,795,000 6.00% 4.75%

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a. What is the estimated cost of common equity for the company? [4 marks]

b. What is the estimated after-tax cost of debt for the company? [4 marks]

c. What is the estimated cost of preferred equity for the company? [4 marks]

d. What is the estimated WACC of the company? [4 marks]

e. What is the implied long run growth rate of the company’s dividends? [4 marks]

Question 2. (20 marks) Your company is considering buying a new factory. The initial cost of the factory is $500,000, but there is an annual maintenance charge of $15,000. The factory will be depreciated over 25 years on a straight line basis (i.e. the depreciation rate each year). Your company plans to sell the factory in 3 years for $400,000. Use of the factory requires an increase in net working capital of $40,000. The 2

factory would increase net operating revenues by $200,000. The company’s marginal tax rate is 40 percent. Assume that all cash flows occur at the end of the respective year. a. What is the total year 0 cash flow? [4 marks]

b. What are the net operating cash flows in years 1, 2 and 3? [4 marks]

c. What is the terminal year cash flow? [4 marks]

d. If the project’s cost of capital is 10 percent, what is the NPV of the project? [4 marks]

e. What is the payback period of the project? [4 marks]

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Question 3. (20 marks) Consider two stocks, A and B, with the following expected returns and betas E(R) A B 9.55% 10.98% Beta 0.80 1.10

The risk free rate is 5.75% a. Assuming that Stock A is priced according to the CAPM, What is the market risk premium? [4 marks]

b. What is the equilibrium expected return of Stock B? [4 marks]

c. Consider Stock C, which has a beta of 0.90. Suppose that you have forecast a return of 8.00% for Stock C. Is Stock C is overpriced, underpriced or fairly priced? [4 marks]

d. Suppose that you construct an arbitrage portfolio to exploit any mispricing that you might have found in Stocks A, B and C. What would the weights of this portfolio be? [4 marks]

e. Suppose that the risk free rate rises by 1%. What is the equilibrium expected return of Stock A? [4 marks] 4

The correlation coefficient between the returns of A and B is 0.3. Short selling is allowed. a. Consider a portfolio, P, that comprises 45% invested in stock A and 55% invested in stock B. What is the expected return, standard deviation and coefficient of variation of P? [4 marks]

b. Plot A and B in expected return-standard deviation space and draw (approximately) the feasible set for P. On this diagram, mark the minimum variance portfolio and the efficient set. [4 marks]...

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...1. Refer to the following information:
Stock | E(r) | | Correlation Coefficients |
1 | 0.06 | 0.20 | 1 with 2: -0.10 |
2 | 0.08 | 0.10 | 1 with 3: +0.60 |
3 | 0.15 | 0.15 | 2 with 3: +0.05 |
A portfolio is formed as follows: sell short $1,000 of Stock 1; buy $1,500 of Stock 2; buy $1,500 of Stock 3. The investor uses $1,000 of his own equity, with the remaining amount borrowed at a risk-free interest rate of 4% (with continuous compounding).
(a) Assuming that there are no restrictions on the use of short-sale proceeds, what is this investors expected rate of return?
(b) What are some of the issues associated with short-selling, and what impact could these issues have on the expected return calculated in part (a).
ANSWER
(a) w1 = -1; w2 = 1.5; w3 = 1.5; wr = -1
E(r) = -1*0.06 + 1.5*0.08 + 1.5*0.15 + (-1)*0.04 = 24.5%
(b) short selling is restricted; unable to use proceeds from the short sale; fee for short selling reduces return. All of these restrictions could fundamentally change the return to the portfolio.
2. Consider a European call option on a stock. The stock price is $70, the time to maturity is 12 months, the risk free rate of interest is 10% per annum (with continuous compounding), the exercise price is $65, and the volatility is 32%. A dividend of $1 is expected in six months time. Determine the price of the option using the binomial method with 6-month steps.
ANSWER
3. The current price of silver is $9 per...

...﻿Finance 301
1. The NPV for the truck and the pulley are $2026.75 and $5586.05 respectively. Since these projects are independent, the company can choose either project. They both will give the company a return higher than 12% as well. (Math is on last page)
2. A. NPV for Alt A is $1892.17 while the payback is 2.86 years. NPV for Alt B is 2289.66 while the payback is 4.62 years. (Math on last page)
B. Since these projects are mutually exclusive only one can be chosen. Since NVP is a better way of estimating value and return, it should be used when picking between two projects. Therefore, the Smith Pie Company should go with alternative B. Even though Alt B has a longer payback period than Alt A, it will look better in the company assets longer and have a better return.
3. CAPM is equal to the cost of capital, which provides a usable measure of risk for the investor and their investment. It let’s investors know if they will get the return they deserve prior to making any decisions. Also, the higher the risk the higher a return could be.
4. A. 11% is the required return on the stock.
B. Beta is .9
C. The company’s cost of capital is 9.8 percent.
D. If the risk of the project is similar to the risk of the other assets, then the appropriate return is the cost of capital, which in this case is 9.8%
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5. The beta for the portfolio is .5 (Math is on last page)
6. The alpha for this portfolio is 1.79 while the beta is .71. What...

...assumptions:
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2. Securities are infinitely divisible; Investors are rational and well informed about the risk-return of all the securities.
Modigliani-Miller model says that the total value of the firm is equal to the capitalized value of the operating earnings of the firm. The capitalization is to be made at a rate appropriate to the risk class of the firm.
Growth Plans, are involved in capital structural theories in which a certain amount will be allocated for the growth plans. A finance manager should draw a plan according for the dividend policy.
For Example: The firm has $10 million as equity capital and $6 million as debt capital and the firm made a profit (after tax) of $2 million, and the fund allocated to the growth plan was $1 million.
For suppose there are 10,000 shareholders in the company and as per capital structural theories some amount will be allocated for the liquidity that is five hundred thousand and the remaining amount should be distributed as Dividends. In this case each shareholder or the owner will receive $50 as dividend.
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...increasing the firm’s market value just by substituting debt for equity. a) If RMO operated in perfect capital markets without any taxes (no corporate or personal taxes), how will RMO’s market value change if the firm decides to issue 50 million € of debt, buying back 50 million € of common stock in return? In this scenario RMO will pay interest only on this debt and plans to hold that amount of debt permanently without further adjustments in the future. (2 points) b) In contrast to a) above assume now that there is a corporate tax with statutory rate of 35% (but no personal taxes). What would be the effect of the same financial transactions on RMO’s value? (5 points) c) Personal taxes on investors’ income (from either interest payments on corporate debt, dividends or capital gains) might offset some of the tax benefits of leverage. Suppose the tax rate on interest income is 35% and the tax rate on dividends as well as capital gains is 10% for all investors. How high must the (marginal) corporate tax rate be for debt to still offer a tax advantage? (5 points) c) The CEO is skeptical about these valuation effects and seeks your advice. She asks whether there are also costs to debt financing not adequately accounted for in these calculations so far. What could these costs of leverage be? (3 points) d) Assume again that there is only a corporate tax with tax rate 35% (like in question b) above; no personal...